The Chinese Economy after Mao

Posted in history of economic growth
Based on Barry Naughton, The Chinese Economy: Adaptation and Growth (MIT Press, 2018), and Arthur Kroeber, China’s Economy: What Everyone Needs to Know (Oxford, 2020)

If there ever was a road to hell that was paved with good intentions, it was Mao’s “socialist road.” The People’s Republic of China was founded in 1949 with Mao as its leader, and there was no significant shift away from Mao’s ideas until 1978, two years after his death. The annual growth rate of per capita GDP during this time was less than 2.5 per cent, and a large majority of the Chinese people were still living in extreme poverty when Mao died. By contrast, China’s capitalist rivals — Japan, South Korea, Taiwan — experienced enormous gains in their living standards over the same years.

Hua Guofeng succeeded Mao and attempted to govern in a similar style, but a reformist faction led by Deng Xiaoping was able to push aside Hua’s agenda and replace it with a much bolder one. The Chinese Communist Party would henceforth emphasize economic development. Its tools would be personal responsibility systems, rewards and punishments geared to performance, and co-ordination through market prices. There would be a devolution of power, and mass movements like the Great Leap Forward and the Cultural Revolution were proscribed.

Being East Asia’s laggard now became an advantage: China could be guided by the experiences of Japan, South Korea, and Taiwan. Arthur Kroeber has identified several ways in which China followed their lead.1

  • Agricultural reform put land under the control of the people who worked it, increasing their incentive to be productive.
  • Export-oriented manufacturing was developed, facilitating the adoption of new technology and setting non-negotiable production standards.
  • Financial repression aided development. Interest rates were kept low to support investors; a managed exchange rate encouraged exports and discouraged imports; capital controls prevented the rewards of successful innovation from being shifted out of the country.

Of course, China implemented these policies in its own way. It was a socialist state and intended to remain one. Westerners might think of decentralized decisions and market prices as the hallmarks of capitalism, but to the Chinese, they were simply useful tools. At no time did the country’s leaders imagine that China was “transitioning to free markets.”

China’s new policies led to extraordinary growth. Per capita GDP in 2019 was twenty-five times greater than it had been in 1979, and extreme poverty had all but been eliminated. The graphs below show China’s growth relative to its East Asian rivals. The first graph has a logarithmic vertical axis, so that growth rates are proportional to slopes.2 China consistently grew faster that its regional rivals, and in proportional terms, it was closing the gap in per capita GDP. The second graph has a linear vertical axis, and shows that for all of China’s tremendous growth, the absolute gap in per capita incomes actually increased.

One further inference can be drawn from the logarithmic graph. The growth rates of the three rivals fall over time, and their per capita GDPs converge. Their starting points might have been different, but they look more and more alike as time passes. Although they are prosperous nations, their per capita GDPs remain well below that of the United States. China’s growth looks very much like that of its East Asian rivals, with a lag of several decades. There is as yet no evidence that China will overtake its East Asian rivals, let alone the United States.

In absolute terms, however, the Chinese economy has been bigger than the American economy since 2016, if a purchasing power parity exchange rate is used to compare the currencies.3

The Chinese Economy in 1978

For three decades after the revolution, the Chinese conception of a modern economy mirrored the Soviet conception: it was an economy dominated by capital-intensive industry that produced chemicals, metals, and machinery. This ideal turned China’s development into an uphill battle. The country was poor, so choosing to invest in plant and equipment meant choosing not to ameliorate the harsh conditions under which the Chinese people lived. The push for capital-intensive industry also blocked the development of light industry that emphasized China’s most abundant factor of production, labour.

Central planning was introduced a few years after the revolution, but it never became as elaborate as Soviet planning. The size of the Chinese economy precluded the use of input-output analysis.

Instead, planners divided blocks of resources among different stakeholders, drew up their own wish lists of priority projects and the resources they needed, and then allocated anything left over to the numerous unmet needs.4

The planning system governed large factories, transportation, and communications. Even within these sectors, its scope was limited: the system never allocated more than 600 industrial goods, as opposed to the 60,000 allocated by the Soviet system.5

Large state-owned enterprises (SOEs) that fell under the system had little discretion, not even the ability to hire and fire. Their workers had an “iron rice bowl” — lifetime employment and guaranteed wage increases. The SOEs also provided health care for the employees and their families, education for the children, and in some cases, subsidized housing. The remaining profits were siphoned off by the state, and were the most important form of government revenue.

Agriculture and much of the rural economy fell outside the planners’ purview. Agriculture was organized into large, village-encompassing collectives in 1955. Mao emphasized local self-sufficiency, so many of the needs of the collectives were satisfied by town and village enterprises (TVEs), small firms owned or sponsored by the collectives themselves. The collectives, like the SOEs, were responsible for providing education and health care to their members.

The expansion of the industrial sector was partly funded by exploiting the agricultural sector. Each collective was annually assigned a “procurement target” (quota) to fulfill. The planners set low prices for the agricultural goods that the collectives delivered, and high prices for the manufactured goods that the collectives bought. This practice left the collectives poor, and there was a large and sustained income gap between rural people and urban people. There were also large disparities across collectives, because collectives with poor land could not adequately fund education and health care.

The collectives were bedevilled by incentive problems. Free-riding was inevitable, and the lack of constraints on the cadres who managed the collectives gave rise to principal-agent problems.6 Barry Naughton identifies additional incentive problems that were created by the government’s narrow focus on grain production:7

  • In order to meet their procurement targets, collectives were forced to plant grain even on land that was better suited to other crops. The production of these subsidiary crops stagnated, and the total value of agricultural output was not maximized.
  • In order to meet their procurement targets, collectives had to adopt very labour intensive methods of production. They also had to use additional inputs, such as fertilizers, whose cost exceeded the value of the additional grain.
  • Each region was expected to be self-sufficient, which prevented a regional specialization of crops that would have been advantageous.

The emphasis on grain production reinforced the disparities across collectives. In regions that were well-suited to it, the collectives thrived. In regions that were not so well-suited, the collectives were forced to adopt unprofitable and self-immiserating production methods just to meet their targets.

The collectives were at the bottom of a rigid hierarchy in which, says Yang Jisheng, every official was “a slave facing upwards and a dictator facing downwards.” The need of the cadres at each level to satisfy their superiors meant that information became increasingly biased as it was passed upwards, ensuring that China’s leaders heard what they wanted to hear. Yang has documented how this system contributed to famine in the years around 1960, leaving more than 30 million people dead (here).

Many rural peasants opted to migrate to the cities, where conditions seemed to be better. They were certainly better for workers who had an “iron rice bowl,” but the migrants all too often joined a pool of temporary labourers who lived with low wages and few services. They became enough of a problem for the cities that the central government introduced a permit system to prevent further migration. The system divided the population into urban residents and rural residents. Without an urban resident’s permit, a person could not get so much as a meal in the city.

In 1978 there were too many people living in rural areas, and too many of them were underemployed. There were too many people working in SOEs that were profitable only because the planners manipulated the prices in their favour, and too many managers who were hamstrung by the planners’ dictats. The reformers of 1978 didn’t have to create an efficient economy. They just had to create one that was less wildly inefficient.

Deng Xiaoping advocated “reform and opening.” Reform meant the restructuring of industry, facilitated by the gradual abandonment of planning and increasing reliance on price signals. Opening meant the acceptance of foreign direct investment and a commitment to world standards in manufacturing; it also meant being receptive to Western science and technology, not just as “catch-up” but as an ongoing initiative. Converting these ideas into concrete policies without sacrificing the principles of socialism proved to be difficult. Deng himself likened it to “crossing the river by feeling for the stones.”

Deng’s goal was radical economic reform without political instability. This goal was achieved in the early years because in such an inefficient economy, it was possible to create winners without losers. Later reforms created both winners and losers. The resulting social unrest reached its climax in Tiananmen Square in 1989.

Reform of the Rural Economy

The foundations of the agricultural reforms of the late 1970s were laid during the terrible famine that had occurred two decades earlier. The incentive effects of collectivization had been evident to China’s peasant farmers, and they had struggled to ameliorate them.

After collectivization, work points were allocated for labor, with remuneration based on work points…This type of allocation tended to result in people putting in a minimum of effort, so meetings were held every evening to evaluate each person’s actual effort that day. Since this involved issues of face, honest evaluations were difficult. The system was further amended to assign work quotas, the satisfactory completion of which brought a certain number of work points. The allocation of work quotas turned into production quotas for work teams, and finally into allocation of production to households. Now land was contracted to a family, with a certain amount of produce handed over to the collective and any surplus retained by the household. The clearer the responsibility, and the closer the relationship between labor and allocation, the greater the initiative applied to the labor in this system, which became known as “responsibility fields.”

However, putting production under the management of individual households shattered the principle of a collective economy with centralized management, collective labor, and centralized allocation, and brought accusations of embarking on the capitalist road. To solve the food supply crisis, some localities managed to disguise the responsibility system, with participation reaching 70 percent in some areas. By May 1962, Liu Shaoqi and Deng Xiaoping believed that production had been individually contracted to at least 20 percent of all peasant households.8

The Central Committee condemned responsibility fields in 1959 for “following the capitalist road.” It did not move against responsibility fields during the famine, but suppressed them when the famine ended. Liu and Deng, their primary advocates within China’s senior leadership, were purged.9 Deng was not rehabilitated until April 1977, but then speedily assembled the coalition that sidelined Hua Guofeng.

In 1978 the collectives were paralyzed by faulty incentives. Per capita grain production in 1978 was the same as it had been in 1955. The production of subsidiary crops was also poor. Oil seed production, for example, fell by a third between 1955 and 1978.10

The reforms of 1978 helped the collectives in two ways. First, they eased the collectives’ financial situation. The procurement targets were reduced, the price paid for grain delivered as part of a procurement was increased, and the price paid for grain delivered in excess of a procurement target was dramatically increased. Second, the collectives were given latitude to experiment with their own organization. Peasant farmers in the provinces of Anhui and Sichuan responded to this initiative by quietly reintroducing the household responsibility system. They were protected and encouraged by their provinces’ governors, Wan Li and Zhao Ziyang. The benefits of the system were soon too great to be ignored, and by the end of 1982, more than 90% of China’s farmers operated under it.

Grain production was one-third higher in 1984 than it had been in 1978. The farmers worked harder each day, and they used more inputs (chemical fertilizers, pumps, small tractors), but they allocated less time to grain production so that they could take on more profitable work.11 Some farmers cultivated more profitable crops, or less profitable crops that required little attention. Oil seed production, so recently in decline, was growing at 15% per year. Meat production was growing at 10% per year. Other farmers engaged in paid employment or their own business ventures. Rural per capita incomes doubled between 1979 and 1984.12

As the rural population grew wealthier, it demanded an array of basic consumer goods that were underprovided by the SOEs. The TVEs, already accustomed to producing simple goods, expanded to satisfy this demand. They used little capital — their expansion was largely funded out of local savings — and they employed the labour that had been released from agriculture. The new products were often extremely profitable. The TVEs were free to set their own prices, but the benchmark was the prices set by the planners, and these prices were kept high to protect the sluggish SOEs. Also, the cost of rural labour was only 60% of the cost of urban labour. The cheapness of rural labour allowed the TVEs to act as subcontractors for urban firms.

Local governments eagerly facilitated the expansion of the TVEs. The profits of the SOEs were remitted to the national government, but the profits of the TVEs remained in the collective. The local governments used some of the profits to provide social services, but they also used the profits to underwrite further expansion of the TVEs, so as to increase their own future revenue streams.

Employment in TVEs grew from 28 million in 1978 to 135 million in 1996. The value-added produced by TVEs was less than 6% of GDP in 1978, but reached 26% of GDP in 1996, even though GDP itself was growing rapidly.13 Their share of GDP declined after the mid-1990s (because the SOEs became more efficient and won back market share) but by this time, rural industry had already played a critical role in jumpstarting China’s manufacturing.

Special Export Zones

Manufacturing for export also played an enormous role in the development of the Chinese economy. Beginning in 1978, businesses from Hong Kong began to sign “export-processing contracts” with businesses in the provinces of Guangdong and Fujian. Most of the contracts were for final assembly of manufactured goods. The components were imported and the finished goods exported without taxes, duties or any other levy. All of the goods were exported, so as not to undermine the ailing SOEs; and the Chinese firms’ activities were not part of the economic plan, giving them much greater freedom. The advantage of this arrangement for Hong Kong’s businesses was access to cheap and efficient labour. The advantage for the Chinese firms was that they were able to concentrate on manufacturing, leaving finance, logistics, and marketing to their more experienced partners.

These contracts proved to be very successful for both parties, in part because they exploited a new technology, the shipping container. Containers simplified the movement of partially finished goods, allowing firms to undertake different stages of production in different locations.

The success of this kind of contracting induced the government to set up four special export zones (SEZs) in the same two provinces. Three were near Hong Kong and Macao, and the fourth was on the coast opposite Taiwan. The SEZs offered access to cheap labour, tax concessions, no duties on imported inputs, simplified customs and administration requirements, and incentives for direct investment. These provinces also invested heavily in infrastructure to satisfy the needs of new industry.

The initial SEZs were a great success, and in 1984, fourteen coastal cities were designated as new SEZs. From the formation of the first SEZs in 1979 until the financial crisis of 2008, the Chinese economy became increasingly open, and trade was a major driver of China’s economic growth.

Foreign direct investment accelerated after 1990, with many new firms being wholly owned subsidiaries of foreign firms. Taiwan’s electronics industry was an early participant in China’s opening. The contract manufacturers Foxconn and Quanta, for example, shifted about 70% of their manufacturing to the SEZs. Japan, Europe and the United States followed their lead. China’s exports quadrupled between 1990 and 2001, and in 2001, more than half of China’s exports were produced by foreign firms.14

Private and State-Owned Enterprises

The need to reform the SOEs was clearly recognized even in the late 1970s. Xue Muqiao, an economist and a member of the Chinese Academy of Social Science, argued that SOEs needed to be given more flexibility.

Xue proposed a number of fundamental reforms, including comprehensive price reform — the readjustment of raw material and commodity prices to reflect their actual value — and the elimination of such traditional practices as “eating from the same big pot,” the system whereby state-owned enterprises received their operating funds di­rectly from the state, turned all revenues over to the state, and required state authorization for all expenditures. Also recommended for elimination was the “iron rice bowl,” the system of guaranteed lifetime employment and standardized, lock-step salaries for all Chinese workers and cadres, re­gardless of individual skill or quality of performance.15

Xue recommended that firms be allowed to hire, fire, and promote their own workers without state interference, and that they be allowed to keep a portion of their profits for investment in “productivity-enhancing measures.” He also argued that managers should be exposed to the marketplace in order to force them to be more efficient. Other economists added to these recommendations: managers and workers should be given performance-based rewards, the formation of privately owned businesses in urban areas should be encouraged, and SOEs that could not earn profits at market prices should be shut down.

These reforms were not easily implemented. The rural reforms created winners without losers, and so did the creation of SEZs, but the reform of the SOEs could not. Some workers would lose their “lifetime employment,” some firms would be shut down, and consumers would have to deal with price deregulation. These things could lead to political instability, and many of China’s leaders valued stability more than they valued reform.

By the mid-1980s, conservative leaders who feared “spiritual pollution” (the loss of socialist values) openly opposed further economic reform. Their views were in accord with those of a significant part of the population:

Throughout the country, those localities, groups, and individuals most highly disadvantaged by reform, or simply afflicted with envy of others more suc­cessful than themselves…took advantage of the antipollution campaign to decry the high costs and adverse side effects of economic reform.16

The problem for Deng and his allies was to push economic reform forward without losing the support of the politburo.

An important step was taken in 1984, when China’s planners capped the absolute size of its allocation, so that the economy would “grow out of the plan.” Each SOE contracted with the planners for the acquisition of specified quantities of raw materials and the delivery of specified quantities of finished goods, at prices dictated by the plan. The SOE was free to produce more goods than the contract stipulated, but it had to buy the raw materials and sell the finished goods on the open market. This scheme allowed the managers of an SOE to experiment with profit-seeking initiatives without having the survival of the SOE ride upon their success or failure. Moreover, their experiments would not lead to unstable markets, because the inframarginal units of goods were fully contracted.

The economy would grow out of the plan because the contracts would become less and less important to growing SOEs, but also because sectors lying entirely outside of the plan were producing an ever greater share of national output. The TVEs and the SEZs were two of these sectors, and private enterprise was another. Private enterprises began to appear in the late 1970s, and became both larger and more numerous in the 1980s and early 1990s. Only “household businesses” (restricted to eight or fewer employees) were allowed in the beginning, but larger “private businesses” were permitted later. They were initially concentrated in rural areas, but slowly infiltrated the urban areas: “It was not until 2004 that employment in businesses registered as private corporations reached 10% of the urban workforce; by 2015 that number reached 28%.”17

Legislation enacted in 1988 split the ownership of firms from management, giving greater authority to the managers of SOEs, and barred local party officials from interfering in the operation of companies. The managers were now able to fire redundant workers, and did so: China’s unemployment rate rose from 2% to 3.5% by August 1988. A bankruptcy law that could be applied to unprofitable SOEs was also introduced, but officials were reluctant to use it for fear of its unemployment repercussions.

At this point, reform stalled again. In the aftermath of the Tiananmen Square protests of 1989, the politburo shifted to the right. Zhao Ziyang, who had been appointed general secretary of the CCP in 1987, and who was Deng’s ally in economic reform, was pushed out of office.18 The premier, Li Peng, allied himself with a senior statesman, Chen Yun, who had once favoured economic reform but now worried about its impact on political stability. Li and Chen counselled a slowdown in the pace of economic reform. However, Deng was able to reassert the centrality of his “reform and opening” policy, and economic reform regained momentum in 1992. Deng, his health in decline, played no further role in Chinese politics.

The ensuing reforms were largely overseen by Zhu Rongji. The reforms of 1992 gave SOEs greater freedom, but also ensured that failing SOEs would be terminated.

The new regulations gave enterprises expanded freedom in such areas as imports and exports, investments, employment (including the right to reject state-appointed workers), pricing, and marketing. The decree also stipulated conditions under which debt-ridden firms would be ordered to stop production and be merged, dissolved, or declared bankrupt.19

Planning was ended in 1993, as was individual contracting with SOEs. A side effect of the freeing of the SOEs was a decline in the state’s revenue: it fell from 33% of GDP in 1978 to 11% in 1995. A new tax system was introduced to grow and stabilize revenue. There were also numerous regulatory changes. The banking and financial sectors were reformed. The Company Law of 1994 required all SOEs to reorganize as limited liability companies, although its implementation was gradual. Securities were regulated under the Securities Law of 1999. The foreign exchange system, which had previously had both an official rate and a market rate, became a managed float in 1993. Further liberalization occurred to facilitate China’s entry into the WTO (agreed in 1999, but phased in after 2001).

A new program was introduced in 1995 under the slogan, “Grasp the big, release the small.” Its purpose was twofold. Mao’s emphasis on local self-sufficiency meant that there were too many SOEs operating on too small a scale. Their numbers had to be reduced to exploit economies of scale. Also, many of the SOEs had undertaken unsuccessful capital expansions and were burdened with nonperforming loans. “Release the small” meant that small local SOEs (local industry, along with local services and retail outlets) would be privatized, or else bankrupted and their assets sold. “Grasp the big” meant that SOEs in pivotal sectors would be rationalized. These sectors included: national networks such as energy, telecommunications, aviation; production of oil, gas, and coal; production of heavy machinery and major consumer goods such as automobiles; infrastructure engineering such as that required for roads and ports; military hardware. The firms in these sectors were arranged into large business groups owned by the central government. The ministries that had previously overseen them were broken up, their functions either abandoned or absorbed by the businesses themselves. There were competing business groups in each sector (for example, three telecom companies rather than one) so as to avoid the adverse effects of monopoly. Competition was even greater in less strategic sectors such as steel production — there were 312 steel producers in 2011. The debt load of the business groups was transferred to the state’s banks. The banks were then recapitalized, but no longer required to extend questionable loans to SOEs. The banks would stay solvent; the business groups would sink or swim.

Taken together, these policies hugely reduced the number of SOEs. There were 262,000 in 1997, but only 110,000 in 2008 and 23,000 (organized into about 100 business groups) in 2018. SOEs accounted for 60% of urban employment in 1995, but only 14% in 2017.20

The economic performance of the SOEs initially improved, but in about 2008, the SOEs began to play a new role. The SOEs grew larger and became more reflective of state policy, but also less profitable and less efficient. The emphasis was on the development of “state champions.” This emphasis was nowhere more evident than in the tech sector. China’s ambitions were laid out in 2015, in the policy Made in China 2025 .

The plan identifies ten high-tech priority sectors, ranging from semiconductors to robotics to new energy technologies, and declares that China should assume a global leadership position in most of these industries within one or two decades. And it specifies targets for the share of domestic and global markets in these industries that should be captured by Chinese firms by 2025 or 2035 — typically, in the range of 40-80 percent.21

This policy reignited foreign concerns about certain aspects of Chinese policy: government subsidies disguised as venture capital, differential treatment of Chinese and foreign firms within China, forced technological transfer from firms wishing to locate within China. It is unlikely that clashes between China and the West over trade matters will subside soon.

At about the same time, the growth rate of the private sector started to fall. There was a slogan for this, too: “The state advances and the private sector retreats.” But by this time, the private sector had irrevocably changed the Chinese economy.

All of the gains in employment since 1978 and most of the improvement in productivity, can be traced to the reallocation of resources from the state to the private sector. The private sector now accounts for about 85 percent of employment and manufacturing output, roughly two-thirds of GDP and fixed investment, half of exports and more than half of the trade surplus.22

The following two figures, from the work of Nicholas Lardy,23 show both the sectoral shift and its impact on economic performance.

The first figure shows the allocation of loans used to finance investments. The value of loans to the private sector substantially exceeded the value of loans to the state sector until 2013. The shares were reversed in 2014, and from then on, state firms have received a far greater share of the loans.

The second figure shows the return on assets (ROA, a firm’s annual profits as a percentage of the value of its assets) in the two sectors. The ROA has been steadily greater in the private sector than in the state sector. The gap between the two returns grows from about 2008, and since 2012, the gap has consistently been about eight or nine percentage points. In 2016 the ROA for state firms was about 2.5%, while the ROA for private firms was about 11%. If investment funds had been efficiently allocated, the share going to the private sector would have risen still further, not fallen. China gave up growth in order to expand its state sector.

China’s Growth Prospects

China’s per capita GDP has grown extraordinarily quickly over the last few decades. It is unlikely that China will be able to maintain these growth rates, but likely that it will continue to grow faster than more established Asian economies like Japan and Taiwan. Even if both of these projections are correct, there is still a lot of uncertainty about China’s future growth. The best way to understand China’s growth prospects is to examine the causes of China’s past growth, and to ask whether they are still active.

Undoing the Misallocation of Resources

The main reason for China’s rapid growth in the 1980s and 1990s was the wretchedness of Maoist economic policies. Collectivized agriculture, stagnant SOEs and the suppression of free enterprise, the pursuit of capital-intensive industry in a country whose principal advantage was cheap labour — these factors meant that China employed its resources in a very inefficient fashion. In the terminology of introductory economics, China was deep inside the production possibility frontier rather than on the frontier. An efficient country has to push out the frontier in order to grow; all China needed to do was move towards the frontier.

Adam Smith believed that people have a “propensity to truck, barter, and exchange.” If left alone, their profit-seeking behaviour will take the economy to the production possibility, or at least close to it. The successes of “reform and opening” were largely a matter of the government choosing to leave people alone. The rejection of Hua Guofeng’s ten-year plan was a decision to not undertake investments that private entrepreneurs would have scorned. The household responsibility system was an initiative of the farmers themselves, appearing when the government gave them more freedom to organize their own work. Free enterprise became the most important contributor to economic growth when the government stopped suppressing it. The special thing about Special Economic Zones was that they were exempt from an array of taxes, restrictions, and interventions. The SOEs were rationalized when the government gave them more control over their own activities, and when it allowed failing SOEs to actually fail.

A self-organizing economy tends to be an efficient economy, and much of China’s early success was a matter of abandoning the ideal of a “command economy” and allowing the economy to self-organize. However, the government does have responsibilities that it cannot abandon. It regulates the financial system and controls the instruments of stabilization policy. It develops and enforces rules, including those that govern the stock market, international trade, environmental pollution, and intellectual property. It provides health care, education, pensions, and other social services. It also collects tax revenue in a fair and transparent fashion in order to fund its essential functions. From the late 1980s onwards, China’s government became increasingly focussed on these things. The government’s understanding of its new function is encapsulated in a slogan put forward by Zhao Ziyang: “The state regulates the market; the market guides the enterprise.”

The big gains from undoing the misallocation of resources have already been realized. The surge in agricultural output that followed the adoption of the household responsibility system will not be repeated, and neither will the explosive growth of the private sector. However, the Chinese economy is large and complex, and there are probably significant pockets of inefficiency remaining. The elimination of these efficiencies would augment China’s future growth.

The biggest threat to the realization of these gains is China’s leaders. They were schooled in communist ideology, so the idea that the economy is not theirs to command is unnatural to them. As late as 1991, Chen Yun, a long-time ally of Deng Xiaoping, argued that the economy should be 80% planned and 20% market-oriented.24 Hu Jintao pushed for bigger SOEs, and the dramatic shift of investment funds towards the SOEs occurred under Xi Jinping. These policies are not undoing old efficiencies — they are creating new ones.

Technology

The ultimate driver of economic growth is technological progress. Advanced economies use the most modern technologies. They grow by developing new technologies, and by adopting new technologies developed elsewhere, so their rate of growth is largely determined by the pace of technological progress. On the other hand, countries that are using outdated technologies can grow by adopting technologies that are better but not necessarily state-of-the-art. Their growth rates are determined by the speed with which they adopt better technologies, not by the speed with which new technologies are developed. The resulting growth is called “catch-up growth,” and it can enable less advanced countries to grow faster than more advanced countries, not just for a year or two, but for decades.

The impact of catch-up growth is shown in the figure below.25 The horizontal axis measures a country’s per capita GDP in 1960, normalized by the per capita GDP of the United States. The vertical axis shows the average annual growth rate of per capita GDP over the next four decades. Each country’s three-letter designation is used to represent its data point. The data form a roughly triangular mass. The upper edge of the triangle shows the possibilities of catch-up growth: the lower was a country’s per capita GDP in 1960, the faster it could grow over the ensuing decades. China (CHN) had one of the lowest per capita GDPs in 1960, and therefore had the potential to grow very quickly. (China’s growth rate in the figure is low because its reforms didn’t begin until halfway through the observation period.)

It is unlikely that China’s catch-up period is over. Its per capita GDP remains well below that of the United States, suggesting that there is ample scope for further modernizations.

Modern technologies are not “plug and play” — there are synergies between the technologies and their human users. The users of a new technology learn how to operate it, and when they have, they can move on to a more advanced technology and begin the learning process again. The sophistication of the technology and the abilities of the users rise together. This observation has two important implications. First, technological progress in any given sector is likely to proceed in steps, with the most modern technologies adopted only in the last step. This stepwise implementation is one of the reasons why catch-up growth can continue for decades.26 Second, the technologies that add most to a country’s productivity won’t necessarily be adopted in the early steps. The SEZs illustrate both points. In the beginning, electronics firms in the SEZs imported components, assembled them, and exported the finished product. The assembly work allowed both the bosses and the workers to learn about the electronics industry. Firms then started to manufacture components, beginning with simple ones and gradually moving on to more complex ones. Chinese firms are now making semiconductors on a contract basis. Assembly was low value-added work, but it was just the first step in the development of a high value-added industry. This example suggests that even though catch-up has been going on for decades, there can still be significant gains ahead.

An interesting, but possibly irrelevant, question is whether China is as inventive as the United States. The answer appears to be that at this time, it is not.

World Bank data on payments for the use of intellectual property, for example, indicate that the United States is far and away the leading source of innovative technologies, boasting $128 billion in receipts in 2013 — more than four times as much as the country in second place, Japan. China, by contrast, imports technologies on a massive scale yet received less than $1 billion in receipts in 2013 for the use of its intellectual property. Another good indicator of the technological gap is the number of so-called triadic patents, those registered in the United States, Europe, and Japan. In 2012, nearly 14,000 such patents originated in the United States, compared with just under 2,000 in China. The distribution of highly influential articles in science and engineering — those in the top one percent of citations, as measured by the National Science Foundation — tells the same story, with the United States accounting for almost half of these articles, more than eight times China’s share.27

This question might matter in 2040 or 2050, but it doesn’t matter now. China’s growth for the foreseeable future will be catch-up growth. Its per capita GDP will not be determined by its inventiveness, or by the sophistication of showcase technologies, but by the overall state of technology within the country. What the farmers are doing will matter just as much as what the semiconductor makers are doing. From China’s perspective, that’s a very good thing. It makes economic growth almost routine.

Demographics

China’s demographics contributed to economic growth from 1980 to 2010. They are now acting as a brake on economic growth, and are projected to do so until 2060.

A country’s demographics are often described by the dependency ratio, which is the ratio of the part of the population that is deemed to be either too young or too old to work, to the part of the population deemed to be of working age. A dependency ratio of 0.5, for example, indicates that there is a young or old person for every two working-age persons. The figure below shows China’s past and projected future dependency ratio (80% means 0.8). The dependency ratio fell from 0.73 to 0.36 between 1978 and 2010: a sharp decline in the number of young people more than offset the modest rise in the number of elderly people.

Another way to think about these numbers is that the working-age population constituted 58% of the total population in 1978 and 74% of the population in 2010. That change provides a nearly automatic boost to per capita GDP, the ratio of GDP to total population. If more people within a given population are working, per capita GDP rises. This factor alone boosted per capita GDP by about a quarter, with the increase spread over three decades. There are other benefits as well. The greater number of workers increased China’s pool of savings. Firms tap these savings to finance their capital investments, so the increased savings led to an increase in China’s plant and equipment, again increasing per capita GDP. The decline in the number of children per family also enabled families to invest more in the future of each child, most notably through advanced education. As these children begin to work, per capita GDP again rises.

China’s dependency ratio is now rising, and it will continue to rise for several decades. The number of children per working-age person has ceased to decline, while the number of elderly persons per working-age person will steadily rise. The net effect is a steadily rising dependency ratio that will approach 0.8 by 2060. Now the demographic effects are working in reverse, dampening the growth of China’s per capita GDP. For this reason alone, China’s per capita growth will be one or two percentage points slower over the next few decades than it was over the last few.

Trade and Politics

China’s past success and future prospects hinge upon its openness to trade, and yet its actions sometimes suggest that it is not an entirely desirable trading partner.

One rule that commonly limits international disputes is that separate issues are not arbitrarily tied together. The dispute between the United States and the European Union over aircraft subsidies, now in its seventeenth year, is one example. The European Union claims that the United States has illegally subsidized Boeing, and the United States claims that the European Union has illegally subsidized Airbus. Both sides took their cases to the WTO, and both sides were allowed to impose retaliatory tariffs. The relationship between the two states nevertheless remains cordial and productive, because both states have refrained from broadening the scope of the dispute. China, by contrast, seems willing to use whatever leverage comes to hand. Australia’s attempts to limit China’s influence within the country prompted China to block imports of Australian coal and beef. Canada’s detention of a Huawei executive in response to an American extradition request caused China to block imports of Canadian canola, and also to arrest two Canadians on spurious charges of spying. China believes that this kind of leverage is a valid exercise of power.

The Boeing/Airbus dispute also shows how aware trading nations are of illicit subsidies. It seems inevitable that Made in China 2025, a policy whose explicit objective is to take market share from other nations, will lead to trade conflicts. This policy, says Kroeber,

provides more evidence that the basic orientation of economic policy under Xi is “state capitalist.” That is, economic assets are controlled primarily by profit-seeking companies, but the state intervenes heavily to direct investment flows to priority industries…Chinese government interventions in the economy are substantially larger in scale, different in quality, and less constrained than interventions in the advanced industrial nations.28

The close connection between technology firms and the Chinese government also leaves some Westerners wondering whether these firms can be trusted. They fear that Chinese technology could be used to steal state or industrial secrets, or to sabotage telecommunications in the event of hostilities. These concerns are given some credibility by China’s National Intelligence Law (2017), which requires Chinese firms to “support, co-operate with and collaborate in national intelligence work.” Security concerns have already led some countries to ban Huawei from their 5G networks. Huawei’s bosses say that they would never betray their customers, but what else would they say?

The question of trust is also brought to the fore by China’s readiness to adopt confrontational positions. China has extended its sovereignty claims over parts of the South China Sea at the expense of Brunei, Taiwan, Indonesia, the Philippines, and Vietnam. Other nations, such as South Korea and Japan, are concerned about the potential for the shipping lanes to fall under Chinese control. China has occupied Tibet since 1950, claims Taiwan to be an integral part of its territory, and has ongoing territorial disputes with India, Nepal, and Bhutan. It is attempting to quash democracy in Hong Kong. China’s persecution of the Uighurs has been broadly condemned, with some Western countries arguing that it constitutes genocide.

Western countries view China as a useful trading partner, but not as a useful ally. For its part, China has sought to extend its influence primarily in the South and among less developed countries. Xi’s belt and road initiative is a major component of this outreach. The belt is sometimes called the “new silk road,” linking China to Central Asia and Europe. Much of the investment is in Central Asia, and to countries like Kazakhstan, this investment is an important part of their efforts to commercialize their natural resources. The road is the “maritime silk road,” consisting of port facilities and connecting road and rail in foreign countries. It links China to the countries bordering the Indian Ocean, and also to the Middle East and Asia. The belt and road initiative serves China in several ways. First, it increases China’s access to the raw materials that it will need in the future. Second, it provides international business for China’s construction firms. Third, it makes many countries strongly dependent on Chinese loans and Chinese business, converting them into de facto allies.

Political Stability

Western observers have long questioned China’s ability to combine authoritarian government with free markets. Competition requires significant independence of thought and action, while authoritarian government requires discipline and obedience. The Westerners believed that the clash between these requirements would eventually bring either less competition or greater political freedom. The Chinese themselves have tended to dismiss this argument. The Chinese have been right so far, and yet the argument does not go away. Xi is significantly more authoritarian than his predecessors. At the same time, he has both strengthened the SOEs and clamped down on some prominent businessmen. It’s possible that these policies are simply two aspects of Xi’s ideology. But it’s also possible that they reflect the conflict between authoritarianism and competition, that Xi could not take greater control of Chinese society without taking greater control of the Chinese economy.

There are many ways in which the political issue could play out. Xi could make the Chinese economy less competitive and less successful, or dissent among China’s senior leaders could moderate his behaviour, or social unrest could lead to greater political freedoms. It is difficult to enumerate the possibilities, let alone assign probabilities to them. Whatever choice China ultimately makes will have a substantial impact on the economy.

  1. Kroeber, China’s Economy: What Everyone Needs to Know, pp. 35-8. ↩
  2. When comparing two curves, or two parts of the same curve, a steeper (flatter) curve implies a faster (slower) growth rate. ↩
  3. The data is from the World Bank. Exchange rates are determined by people’s desire to swap one currency for another. They might wish to swap currencies in order to buy or sell goods, or in order to move financial capital between countries. A purchasing power parity exchange rate is an estimate of what the exchange rate would be if the only swaps were those motivated by a desire to trade goods. ↩
  4. Naughton, The Chinese Economy: Adaptation and Growth , p. 71. ↩
  5. Naughton, The Chinese Economy: Adaptation and Growth , p. 72. ↩
  6. A free-rider problem occurs whenever someone’s rewards are independent of his effort. The effort expended by peasants working in a collective did not affect their material rewards, so they were inclined to conserve their energy. A principal-agent problem occurs when a manager is able to act in ways that advance his interests rather than those of his superiors. The managers of a collective controlled work assignments, housing and the allocation of food, giving them ample scope for nepotism and favouritism. Yang Jisheng has observed that managers did not starve during famines. ↩
  7. Naughton, The Chinese Economy: Adaptation and Growth, pp. 266-7. ↩
  8. Yang Jisheng, Tombstone: The Great Chinese Famine, 1958-1962, p. 441. ↩
  9. At the time of his purging, Liu had been the third most powerful man in China, and had been seen as the eventual successor to Mao. Deng had been vice-premier, second to premier Zhou Enlai. ↩
  10. Kroeber, China’s Economy: What Everyone Needs to Know, p. 50. ↩
  11. The number of labour days per hectare planted in rice fell from 908 in 1978, to 643 in 1985, 178 in 2004, and 93 in 2015. The number of labour days per hectare planted in wheat fell from 461 in 1978, to 218 in 1985, 122 in 2004, and 70 in 2015. (Naughton, The Chinese Economy: Adaptation and Growth, p. 269. ↩
  12. Kroeber, China’s Economy: What Everyone Needs to Know, p. 51. ↩
  13. Naughton, The Chinese Economy: Adaptation and Growth, p. 310. ↩
  14. Kroeber, China’s Economy: What Everyone Needs to Know, p. 73. ↩
  15. Baum, Burying Mao: Chinese Politics in the Age of Deng, p. 95. ↩
  16. Baum, Burying Mao: Chinese Politics in the Age of Deng, p. 164. ↩
  17. Naughton, The Chinese Economy: Adaptation and Growth, pp. 339. ↩
  18. The protesters were forcibly dispersed by China’s military in what is now commonly called the Tiananmen Massacre. In the lead-up to military action, Zhao repeatedly but unsuccessfully attempted to initiate negotiations between the protesters and the government. His actions were later described as “splitting the party,” leading to his removal. ↩
  19. Baum, Burying Mao: Chinese Politics in the Age of Deng, pp. 355-6. ↩
  20. Kroeber, China’s Economy: What Everyone Needs to Know, p. 128. ↩
  21. Kroeber, China’s Economy: What Everyone Needs to Know, p. 78. ↩
  22. Kroeber, China’s Economy: What Everyone Needs to Know, p. 135. ↩
  23. Nicholas Lardy is the author of two books, Markets over Mao (2014) and The State Strikes Back (2019), that discuss the shift toward markets under Deng Xiaoping and Jiang Zemin, and the resurgence of state firms under Hu Jintao and Xi Jinping. ↩
  24. Baum, Burying Mao: Chinese Politics in the Age of Deng, p. 337. ↩
  25. This figure is a version of Figure 3 in Charles Jones and Paul Romer, “The New Kaldor Facts,” American Economic Journal: Macroeconomics (2010). ↩
  26. Another reason, which is complementary to the first, is that new technologies involve capital investment. The pace at which a firm modernizes will be limited by its ability to obtain the necessary investment financing. ↩
  27. Stephen Brooks and William Wohlforth, “The Once and Future Superpower: Why China Won’t Overtake the United States, Dartmouth Faculty Open Access Articles (2016), pp. 92-3. ↩
  28. Kroeber, China’s Economy: What Everyone Needs to Know, p. 285. ↩